Under the stagflation scenario, oil prices are assumed to push higher to settle above $130 per barrel. Moreover, the ongoing war in Ukraine would adversely affect food prices in 2023. These factors could lead to inflation rising more than anticipated and peaking later, thus kindling inflation expectations.
Inflation would therefore fall back at a slower pace than the Fed’s June projections—staying above 4% well into 2023, and staying at around 3.5% thereafter, as the dotted line in Figure 2b shows.
In such a scenario, the Fed would have to play catch-up by raising rates even more aggressively to combat high inflation and rising inflation expectations. Our model suggests that rates could rise above 5% under this scenario, with a high likelihood that the amount or pace of these hikes would surprise financial markets.
Such an extreme move in policy rates would certainly dampen inflation but also provoke a severe recession, with the output gap widening to –1.5% of GDP in 2023, as shown by the solid line in Figure 2c. This is a much wider gap than the –1% in the hard-landing scenario where the Fed eventually backs off from intended rate hikes.